Present Value, an independent editorial project produced and hosted by Johnson students, had the pleasure of interviewing Mark Nelson, the Anne and Elmer Lindseth Dean of Johnson (pictured left, above), and Robert Libby, professor and accounting area coordinator (pictured right, above).

Present Value can be streamed through the Present Value website, or listened to through iTunes, Spotify, and other popular podcasting apps by searching for “Present Value.”

The slippery slope of earnings management

Earnings management is the practice whereby managers alter financial reports or alter their normal business practices to intentionally misrepresent an organization’s financial performance. While it could be argued that every manager is, in some sense, trying to “manage” their earnings by utilizing ordinary legal tactics such as increasing promotions to grow revenue or spending less to reduce costs, managers fall down a slippery slope when they look to take advantage of accounting rules to either overstate or understate their earnings (fraudulent managers can have reasons to do either). In this episode of Present Value, Dean Nelson and Professor Libby discuss the nuances of earnings management with a focus on revenue. Libby comments that it can be more interesting to discuss overstated revenue because you can understate expenses “but the amount is limited to the amount of expenses… whereas revenues can be overstated by an infinite amount.”

To make it easy for the listener, Nelson shares a straightforward earnings management example: a manager delays a shipment of goods until after the quarter ends in order to delay the recognition of revenue for the shipment. This practice may be used by a manager who has met their budget for the quarter, and therefore wants to get a head-start on the next quarter. While permitted by GAAP, this practice distorts revenue in both quarters. A similar practice could be used to accelerate revenue, by counting shipments still on the shipping dock as revenue for the current quarter, when those shipments were in-fact delayed and not shipped out, for circumstances such as weather. That practice however is not permitted by GAAP, as the manager would be treating unshipped items as if they had been shipped.

While these examples may seem innocuous, Libby points out that there is a slippery slope in committing accounting fraud: small acts of earnings management lead to larger acts in the future—emboldened by those earlier, smaller instances of bending the rules. Further, Libby explains that because accounting frauds are often only uncovered during once-a-year audits, a lag in regulatory checks and balances can lead managers to continue to commit financial accounting fraud for several quarters (Libby notes that fraudulent managers typically can only keep up the charade for five quarters).

Falsehood, the bad and ugly

Libby explored several egregious real-world examples of earnings management that were prosecuted by the S.E.C: Home-Ex in Mexico fabricated over $3.3 billion of revenue from homes that were later revealed by satellite imagery to be nonexistent; and Le-Nature’s, a natural beverage company, overstated earnings by $200 million and secured $800 million worth of debt against the false earnings. The latter fraud resulted in a cumulative 70 years in federal prison for nine individuals. Libby uses these flagrant examples in his MBA classes to demonstrate the real-world consequences of financial accounting fraud.

Changing revenue recognition rules: a new opportunity for financial fraud?

New revenue recognition rules (ASC606) were established for the U.S. in conjunction with the International Financial Reporting Standards (IFRS) to provide a single revenue standard across industries while also aligning with international standards. Previously, under SAB 101, companies operated on a realization principle (recognizing revenues once the associated goods or services have been delivered or rendered). Beginning for all companies at the end of 2018, firms must now recognize revenue according to when firms have satisfied performance obligations indicated in contracts between a seller and their customer.

An example used in the podcast to illustrate this difference is a bonus for a consulting firm that is only payable at the end of the year if a certain performance criterion is met. Under previous SAB101 standards, revenue would only be recognized when the final bonus criterion was met. The new ASC606 standard however, guides firms to estimate at the inception of the contract how much bonus eventually will be earned, and then recognize bonus revenue over time as performance obligations are satisfied. This leaves it up to managers and firms to determine the likelihood that their organizations will meet the performance criterion necessary to receive the bonus. This practice provides a more accurate economic view of revenue throughout the year, but if the firm doesn’t meet the performance criterion, they must deliver some very bad news to investors and reverse out the bonus revenues already recognized on their income statement.

As Nelson reflects in the podcast, “markets depend on information, and markets also depend on confidence in that information.” So although this new guidance provides increased transparency to the market and for potential investors by revealing more information about revenue as performance obligations are satisfied, the rules also leave much to the discretion of managers in estimating how much revenue eventually will be realized.

Nelson and Libby believe that the first financial frauds under this new standard will involve manipulating estimates of future revenues for long term contracts. They both worry that these acts will be harder to catch and harder to prosecute. Looking ahead, they are both intrigued about how the new regulations will impact manager behavior and how firms will apply and disclose their revenue recognition estimation methods. Although increased financial transparency will be useful to investors for firms that don’t commit financial fraud, the new standards are already making internal controls and auditing functions even more critical.

About Mark Nelson

Mark Nelson is the Anne and Elmer Lindseth Dean and professor of accounting at Johnson. His research examines the psychological and economic factors that influence financial decision making in the field of accounting. He served on the Financial Accounting Standards Advisory Council for four years, has received multiple achievement awards both for his research and his teaching, and is an author of a best-selling intermediate accounting textbook.

About Robert Libby

Robert Libby is the David A. Thomas Professor of Management at Johnson and teaches the accounting core for incoming MBA student. His research examines the interplay among managers’ financial reporting choices, analysts’ forecasts, and audit strategies. He has received multiple achievement awards for his research and teaching and is the author of multiple best-selling accounting textbooks.